I Wouldn’t Touch These 2 Mortgage REITs, Even With Yields Over 16%. Here’s the 10%-Yielder I’d Buy Right Now.

The 10-year Treasury yield recently touched a 24-year high at nearly 5.3%. The surge in this benchmark rate has driven down mortgage REIT stock prices, boosting their yields. Leading residential mortgage REITs AGNC Investment (NASDAQ:AGNC) and Annaly Capital Management (NYSE:NLY) both currently yield more than 16%. While that's alluring to an income-seeking investor like me, I wouldn't touch them right now.

Instead, I've been buying shares of commercial mortgage REIT Ladder Capital (NYSE:LADR), which currently yields more than 10%. Here are a couple of key differences that make it stand out in an environment of rising rates.

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Why I wouldn't touch Annaly or AGNC Investment

Annaly Capital and AGNC Investment have very similar business models. The REITs primarily invest in Agency MBS (pools of residential mortgages guaranteed against credit losses by government agencies such as Freddie Mac). About 99% of AGNC's $97.2 billion investment portfolio is Agency MBS, while 87% of Annaly's $109.4 billion portfolio is Agency MBS (it also invests in residential credit assets ($10.4 billion) and mortgage servicing rights ($4.1 billion)). These mortgage and mortgage-related investments are relatively low-risk fixed-income investments.

Both REITs use leverage to boost returns (AGNC currently leverages its portfolio 7.4x, while Annaly's is 5.6x), which drives 11%-16% returns for Annaly across its portfolio in the second quarter and 15%-17% for AGNC. However, it also increases their risk profiles.

These REITs are more like banks in that they make money on the spread between the income generated by their mortgage portfolios and their financing costs. Because they invest in fixed-rate mortgages, the spread narrows when rates rise as their borrowing costs increase (they typically borrow short-term). This causes earnings volatility, which has led both REITs to cut their dividends several times over the years.

However, they have delivered more durable dividends in recent years: AGNC has maintained its current rate since its last cut in 2020, while Annaly has raised its dividend twice over the past few years as its earnings have improved. Still, given the potential impact of rising rates on their earnings, I wouldn't touch either REIT in the current environment.

What makes Ladder Capital a potential rising-rate winner

While Ladder Capital is a mortgage REIT, it has an entirely different business model, focusing on commercial real estate. It currently has a $5.8 billion investment portfolio across first mortgage loans (49%), investment-grade securities (33%), and commercial real estate equity investments (18%). These are higher-risk investments compared to Agency MBS, with higher return profiles.

Ladder Capital's loan portfolio is a differentiator in the current market environment. It primarily invests in short-term, floating-rate loans (88.9% of its loan portfolio). Meanwhile, it finances its balance sheet with fixed-rate debt. As a result, its earnings should increase as rates rise. Ladder Capital's management team noted on the second-quarter call that every 25 to 50 basis-point rate increase will boost its quarterly earnings by about $0.02 per share.

The REIT also has a large portfolio of AAA securities that had an average yield of 5.15% at the end of the second quarter. As these investments mature, Ladder can roll them into higher-yielding loans (with an average rate of 7.2% in the second quarter), adding another growth driver in today's rising interest rate environment.

Another factor that makes Ladder different is its balance sheet. It's the only investment-grade-rated commercial mortgage REIT, with a low 2.3x leverage ratio (at the lower end of its 2.0-3.0x target range). Its strong credit rating enables it to borrow at lower rates than non-investment-grade borrowers.

Finally, Ladder has an equity real estate portfolio primarily consisting of net lease properties with investment-grade tenants. They provide it with a stable, steadily rising stream of long-duration cash flows, helping reduce the volatility of its earnings.

These factors drive Ladder Capital's expectation that it can grow its earnings, which should support future dividend increases. Even though the REIT has also cut its dividend in the past, it's currently in a strong position to continue increasing it.

While Ladder has many positives, it's not a risk-free investment. Unlike Agency MBS, commercial mortgages carry default risk (it foreclosed on an $8 million office loan in the second quarter, while another $13.4 million loan entered non-accrual status in the period). Office foreclosures stemming from the pandemic led to its last dividend cut. It currently has a low exposure to the office sector (21%) and a more diversified portfolio overall (multifamily is 58%, industrial is 8%, while other commercial real estate-backed loans comprise the remainder).

I'm passing on AGNC and Annaly's higher yields in favor of Ladder's dividend growth potential

AGNC Investment and Annaly Capital offer alluring dividend yields these days. However, they're too high risk for me in an environment where the Fed is raising rates. That's why I wouldn't touch them right now.

Instead, I'm buying Ladder Capital. While it offers a lower current yield, it's in a strong position to grow its dividend. That's a better fit for my investment strategy.

Matt DiLallo has positions in Ladder Capital. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.